Oct 26, 2017

The Fed's Demographics Dilemmas

By Gene Balas

Can the Federal Reserve achieve its dual mandate of low unemployment consistent with price stability? It’s achieved low unemployment, but it has been lacking in its inflation mandate, which has shown few signs of a meaningful acceleration so far. Fed officials are reluctant to raise the short term interest rates they control quickly, only doing so at a hesitatingly gradual pace until they can be more assured inflation will rise toward its target. Its failure to do so prompts the questions of whether the soft inflation is temporary, and due to factors that will fade or even reverse, or it is from some more entrenched, permanent fixture in the economy, whose origins may as yet be unclear.

This dilemma of inflation not responding to traditional monetary policy solutions as it once had done invites many questions. One pair of questions might be whether inflation is determined by demand, as we argue in our paper that explores these issues in depth, or is it determined by costs, particularly wages? In other words, does inflation originate from the need to pay workers higher wages when job openings become hard to fill, as is conventional wisdom? Or does inflation originate from consumer spending, sourced, in this case, from the proportion of the population in their peak earnings years relative to other age groups?

The prevailing economic argument is that, when unemployment falls low enough, there will be too few qualified workers willing to work at wages on offer. Companies would then be forced to pay higher wages, and pass along those higher costs to customers in the form of higher prices. This concept is known in economics as the Phillips Curve. Historically, it has had a visible relationship with inflation, and in particular wage growth: When the unemployment rate fell, inflation rose almost in tandem.

But this argument hasn’t held true in recent years. Something seems to have shifted in the economy, and Fed officials and economists have taken note. It is a puzzle, and while we won’t attempt to solve it here, we can point to another factor: Inflation may now be driven not just by labor and other input costs as it had in the past. Instead low inflation may also result from an aging population with a growing number of retirees and very little growth in the labor force of prime age workers.

In this line of thinking, lower interest rates alone might not result in more demand and higher inflation. But artificially keeping interest rates too low in the hopes that it will revive inflation of goods and services risks a different type of inflation, that of asset prices. When, as a result of too-loose financial conditions, the prices of homes, buildings, stocks, and bonds become divorced from their fundamental, intrinsic value, financial stability could be eventually put at risk.

Thus, there is perhaps a compelling case to focus not on too-low real economy price increases, but by financial market prices that eventually may become too high. We are not saying that asset prices, while arguably pricey, are now unequivocally grossly overvalued by any means. However, we are pointing out that central bankers may emphasize any emerging risks from overly accommodative monetary stimulus applied for longer than the economy might need. Indeed, the Fed is mindful of these issues and actively discusses financial market conditions in its deliberations.

Not surprisingly, this puts the Fed in a bit of a dilemma. Listening to individual Fed officials speak on the subject of monetary policy, you’ll hear just how varied some officials’ views are on the subject. And looking at the wide range of where individual policymakers believe the short term rates would (or should) be in a year or two’s time, and you’ll similarly get a perhaps-perplexing view of where rates might end up. We’ve examined a very complex issue from just one angle, that of demographics. There are many other facets to these considerations besides what we’ve covered here. The role of a central banker is far from easy, to be sure.

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